There Actually Are Some Good Tax Reform Ideas Out There

Updated:
Posted in: Tax and Economics

It is not clear when the Republicans in the House and Senate will turn their attention to the tax code. There are certainly plenty of things standing in their way, for which we should all be thankful.

The latest blowup regarding the connections between the Trump campaign and the Russian government is keeping everyone busy, of course. This is especially worrisome because there are not many days left to deal with must-pass legislation, such as government appropriations bills to prevent another shutdown. And then there is the unhinged refusal by some Republicans to deal sensibly with the debt ceiling, which will needlessly waste more of Congress’s time when it finally has to be increased.

Even so, when it comes to transferring money from poor people to rich people, Republicans no longer limit themselves to tax and budget policies, as their so-called health care bills so amply demonstrate—combining spending cuts for both Medicaid and health insurance with tax cuts that will almost exclusively benefit rich people.

Even without a big new tax plan, therefore, the Republicans can still do real damage to the country. And if they do ultimately get around to changing the tax system, their ideas for doing so are uniformly terrible. As I wrote recently, it would be much better to keep the current, highly imperfect tax system than to move to anything that Republicans have proposed.

But that does not mean that there are no good ideas out there regarding tax reform. It only means that those good ideas must await the day when the current fever gripping the Republican party has passed, or (more likely) when voters decide to turn the dysfunctional party of the rich out of power.

What would good tax reform look like? My most recent Verdict column set the table for this discussion by pointing out that tax reformers should not aim to completely rewrite the tax code, nor should we allow calls for simplification to be used as Trojan Horses to give tax cuts to the rich.

With those distractions aside, it is now possible to describe how we could change our current tax code in ways that would actually help to fight inequality, which is the most important economic problem facing this country going forward.

The short version is this: We should adopt tax policies that reverse the system’s current built-in advantages for people with high incomes. There is, in fact, a surprising amount of room to talk about progressive tax reform that has nothing to do with arguments about tax rates.

The Importance of Taxing Large Accumulations of Wealth

The Republican Party has spent decades trying to convince people that the federal estate tax must be repealed. They have devoted serious time and effort (and money) to test-marketing slogans and bogus arguments intended to mislead people into thinking that the estate tax is unfair.

This is where the term “death tax” comes from, even though less than one-half of one percent of all deaths result in any estate tax liability at all. The estate tax is not a tax on death, it is a tax on large concentrations of wealth—collected at the time when the person who holds the wealth no longer has any further need to spend it.

Republicans, of course, would have everyone believe that the estate tax “punishes” people who virtuously built up their bank accounts through hard work and sacrifice. But that is not how the vast majority of large estates are built. Like Donald Trump, most people who have enough wealth to pay wealth taxes are rich because they started out rich.

In a classic 1954 film, “The Barefoot Contessa,” one of the main characters is in fact a very Trumpian figure. Rude, boorish, entitled, he is the son of a rich person who thinks that he can treat people shabbily because he has inherited an enormous amount of money.

At one point, he and another wealthy trust fund baby get into an argument at a party. The Trump-like character angrily shouts: “You’ve never done an honest day’s work in your life!” The other multimillionaire replies:

I have never done a day’s work in my life – honest or dishonest, but neither have you. To make 100 dollars into 110 dollars, this is work. To make 100 million into 110 million, this is inevitable.

Republicans tell anyone who will listen that it is just so terribly unfair to tax these poor little rich boys and girls. They make up stories about family farms and businesses that are broken up by the estate tax (even though that has never happened), talk endlessly about double-taxation, and on and on.

But if we really cared to do something to deal with the root cause of rising inequality, we would be looking at ways to tax wealth more effectively, rather than eliminating the estate tax. This would also have the advantage of raising revenues for the government, which could be used to improve the lives of people who did not win the parental lottery.

Why Should Rich People Be Allowed to Decide When To Pay Their Taxes?

As I described in my Verdict column earlier this week, one of the little-known facts about the U.S. tax system is that Congress has given people whose incomes are derived from investments rather than from work the ability to delay their tax payments.

That is, if I am getting richer because my investments are rising in value, I do not have to pay any tax on that income unless I decide to “realize” the gains by selling the assets. I can buy a stock for one dollar and, if I am lucky, watch it rise over the years to $1,000 or one million dollars in value; but if I never sell the asset, I never have to pay taxes on the income.

This means that if Person A’s income in a given year is $100,000 and is derived from earning a salary, she will owe taxes in that same year, whereas Person B will pay no taxes if his $100,000 in income is derived from capital gains (that is, from increases in the value of his assets).

None of this is news to tax specialists, but it is one of the biggest giveaways in the tax code, because these delayed taxes can in many cases be put off for decades, or even forever.

The ability of rich people to game the timing of their tax bills can, in fact, have unexpected consequences. Most interestingly, the Treasury Department announced recently that the “drop-dead date” for increasing the debt ceiling will be significantly sooner than expected.

Why? Because rich people are anticipating that the Republicans are going to give away the store with tax cuts to the rich later this year, which means that even the people who might have decided to realize some of their gains this year are putting off those transactions until later, after the Republicans have reduced rich people’s taxes. This results in reduced tax revenue this year, which means that we will incur more debt and bump up against the debt ceiling sooner.

Again, this is not some deep dark secret. Allowing people to delay paying taxes on unrealized gains is a persistent problem that tax scholars have tried to deal with through a number of different proposals.

Both as a matter of politics and also because of some genuinely persuasive reasons, it makes sense not to require that homeowners pay taxes on unrealized gains in the value of their houses. Otherwise, however, it makes little sense to tax income earned from working right away while allowing people with investments to delay taxes indefinitely.

This is not the place to get into gory details about how to tax assets, but the basic idea is that the U.S. could adopt what tax nerds call “accrual” taxation, where net increases in assets’ values are quite properly taxed as current income.

Of course, no system of accrual taxation is perfect, and the lobbyists for wealthy Americans have spent a lot of money talking up the various ways in which a non-realization regime would be imperfect. But if ever there were a case of the perfect being the enemy of the good, this is it.

Ending Preferential Tax Rates for Rich People

Beyond the wealth and timing issues that I described above, the other area in which the tax code currently favors rich people is in providing lower tax rates on capital gains compared to tax rates on regular income.

The current rule allows people in the lowest regular income tax brackets to pay no capital gains taxes, while people who are not in the top income tax bracket pay 15% and people in the top bracket to pay 20% on capital gains income.

That is a significant discount. A single person with taxable income above $418,400 in 2017 would pay a tax rate on her next dollar of income of 39.6% if the income was in the form of salary, but that next dollar would only be taxed at 20% if the income is from a capital gain.

An astonishing amount of the complexity in the tax code is driven by Congress’s decision to allow investors to pay lower tax rates than people whose money comes from working. Just to take one example, what has come to be known as the “carried interest loophole” would go away if capital gains were taxed at the same rates as regular income.

The much-lauded bipartisan tax bill that Ronald Reagan and congressional Democrats passed in 1986 did, in fact, eliminate the preferential rates for capital gains. Unfortunately, that parity was eliminated very soon thereafter.

There would be an additional advantage to equalizing rates on regular income and capital gains. I mentioned in my most recent Verdict column that most of the thirty percent of Americans who itemize their tax deductions actually have rather simple tax returns. This is because most of us deduct mortgage interest, state and local taxes, charitable contributions, and a few familiar items like those.

For such people, filling their taxes is admittedly less simple than the 1040-EZ form that most people can use, but it is still not particularly challenging to fill out such returns. The political hue and cry about the number of words or pages in the tax code is designed to make us think that the tax code is horribly complex, but for most of us, it really is not.

Even so, there is a genuine complication that arises for upper-middle-class people who do have some realized capital gains in a given year. Because they can pay a lower rate by reporting the income as capital gains rather than regular income, there is a strong incentive to do so.

The form that people must use for that purpose, however, is truly complicated. It has, in fact, tripped me up on more than one occasion. But if the tax rates were the same on both regular and capital gains income, there would be no need to fill out the different form at all. That would be genuine simplification.

What About the Tax Rates Themselves?

Notice that of the three categories of possible tax reform that I have discussed above—the estate tax, taxing unrealized gains, and eliminating the preferential tax rates for investment income—only the first is actually an argument for achieving a more progressive system by raising the current tax rates.

It is frankly insane that Congress settled on the current system of exempting more than $11 million of estates from taxation and then imposing rates that top out at 40 percent. We can and should reduce the exemption amount and make the rates more progressive.

But the other two categories are not arguments about rates at all. We could have any set of tax rates that we like, but it would always be more progressive not to give rich people the advantages that the realization requirement and lower capital gains taxes give them.

This is not to say that I would not also be in favor of increased tax rates on higher-end taxpayers. The best economic research that I have seen suggests that the top income tax rates in the U.S. should be set in the range of 75 to 80 percent for very high incomes.

Moreover, I have not even mentioned the advantages that international tax rules provide to corporations and wealthy people. This column is already long enough.

The point is that the tax code could be make simpler and fairer both by resetting rates and by fixing the gaping loopholes that the current system provides for the richest Americans.

Unless congressional Republicans become interested in true tax reform, however, we should at least stop them from making the tax code even more tilted toward their donors.

  • Brett

    When a far-left liberal such as Mr. Buchanan advocates taxing wealth at even higher rates than the current high rates, which are at a higher percentage than other income levels, the person argues for unfairness (at a level even stronger than the current system) and attacks hard work and the American dream. It is unfortunate that these individuals do not argue that government should spend less for the benefit of taxpayers and the economy.

    • TZ

      Why should anyone argue about whether tax policy is fair? Fair is subjective and usually means the speaker wants their taxes lower. Why should it be fair anyway? The American dream is not real for all. Hard work does not guarantee wealth. The world is not fair. The rich get far more benefits from government spending than the poor. The rich have the money. We the People need funds to run the country. The rich should pay the bill or get the hell out if they do not want to do their part in making this the Greatest Country in the World. Stop your foolishness, freeloader. Freedom isn’t free.

  • Frank Willa

    Professor, thank you for the analysis that shows the ways that all increases in wealth are not the same, and are not treated equally. Allow me to express some of my views with these comments. Nor, as you point out are they taxed the same, the rationalization that money has a different character if it earned through labor rather than investment was important to setting up the disparate treatment. The decision that income is taxed annually- cash basis timing rather than accrual seems to be the point where the discrimination stems. By using that distinction there grew a separate rate of taxation; but why? The accountants carry the increase in long term assets on the books and got the system to follow their lead; claiming unfairness if they were forced to pay tax each year as they went along- alleging it would require sale of some assets to pay the tax. Whereas, wage and salary income earners have the cash as they go along and can simply reserve an amount to pay the annual bill. So, the reasoning to let them pay when they part with the asset was set in motion. So if you decide to hold a stock, or a building, for ten years and then sell, watching the value increase each year, is it not fair to pay a the rate you would have had you held it for a year and sold it? And for emphasis, again, I ask why should there be a different rate of tax; is not a dollar a dollar no matter when you put it in your pocket?
    P.S. To Justia and Disqus: I click to post my comments and often wait two or three days to see them while they are being “reviewed”. I see some people’s comments posted within an hour or two? Why does this happen? Does it happen to many others that follow Verdict and post comments? Are the writers of the columns aware of the days of delay in postings in response to what they have written? (I would like to think they care what their readers’ responses were to articles, perhaps in the days of delay they think no one responded) I would be pleased to assist the process to speed the timing if that would help. Thank you.